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How to use pricing to create an effective hedging program
12-12-2022 | treasuryXL | Kantox | LinkedIn |
In this article, we explore the links between pricing and creating an effective currency hedging strategy. We reveal how a simple PEG framework —Pricing, Exposure, Goals— can allow CFOs and treasurers to correctly define their FX goals, the type of exposure they need to collect and process, and the best hedging program for their business.
Pricing as a hedging mechanism
Transactional currency risk, it is often said, occurs between the moment an FX-denominated transaction is agreed upon and the moment it is settled in cash.
That’s OK, but what if the transaction was priced well before it was agreed, which is a realistic description of how things really work?
That’s why at Kantox, we developed the concept of pricing risk. pricing risk is the risk that between the moment an FX-driven price is set and the moment a transaction is agreed upon, a shift in the FX rate might impact budgeted profit margins.
Closely related to this is the idea that pricing is itself a hedging mechanism. Why? Because you can remove pricing risk by frequently updating your prices.
And that brings us to the topic of pricing parameters and hedging.
Dynamic pricing
Let us start with dynamic pricing. There is a growing list of industries where dynamic pricing is becoming the norm: travel, chemical traders, hospitality, railways, entertainment, insurance, online advertisement, retail and even shipping.
This trend reflects the fall in transaction costs made possible by the availability of real-time data and the rise of geolocation services and payment apps.
Meanwhile, algorithms take into account supply and demand conditions, competitor pricing and other variables.
Two things need to be considered when it comes to dynamic pricing:
(a) prices are ‘FX-driven’; that is, an FX rate is systematically part of the pricing formula;
(b) prices are frequently updated, therefore leveraging the full capacity of pricing to act as a hedging mechanism.
Other pricing models
Despite its growing popularity, dynamic pricing is not the only pricing mechanism out there. We can single out at least two other very significant models:
1. Steady prices for individual campaigns/periods. Some businesses, like catalogue-based tour operators, keep prices stable for an entire campaign/budget period and set new prices at the start of the following period. Things to consider here:
(a) Prices are also FX-driven, just like in dynamic pricing.
(b) The pricing impact of the ‘cliff’, or a sharp FX rate fluctuation between two campaign/budget periods, is fully passed on to customers at the onset of a new period. Here too, pricing acts as a hedging mechanism, but not to the extent it does in dynamic pricing.
2. Steady prices for a set of campaigns/periods. Some firms need or simply desire to keep prices steady not only for one individual campaign/budget period but for a set of campaign/budget periods linked together. Things to consider:
(a) Prices are not FX-driven: the FX rate plays no role in pricing;
(b) The pricing impact of the ‘cliff’ cannot be passed on to customers at the onset of a new period. Pricing, quite obviously, is not a hedging mechanism in this case.
Putting it all together: the PEG framework: Pricing-Exposure-Goals
The PEG or Pricing – Exposure – Goals framework provides actionable clarity when discussing pricing and currency hedging in the context of cash flow hedging programs:
For firms with frequently updated FX-driven prices, the goal is to protect the dynamic pricing rate in all their transactions. The exposure to hedge is the company’s firm sales/purchase orders. The right program is a micro-hedging program for firm commitments.
For companies that keep steady prices during individual campaign/budget periods, the goal is to protect the campaign/budget rate. The exposure to hedge is the forecasted revenues and expenditures for that particular campaign. The right program is a combination of a static hedging program, conditional orders and a micro-hedging program for firm commitments.
Finally, for firms that keep steady prices across a set of campaign/budget periods linked together, the goal is to smooth out the hedge rate over time. The exposure to hedge is a rolling forecast for a set of periods linked together. The right program is a layered hedging program.
Currency Management Automation solutions allow you to reach all your goals, whatever the pricing parameters of your business.
Embedded Finance Explained, by François de Witte
08-12-2022 | François de Witte | treasuryXL | LinkedIn | As embedded finance continues to evolve, there is an opportunity for treasurers to explore how these developments could help their businesses. The present article explores what embedded finance really means, what’s driving progress in this space, and where should treasurers begin.
ESG in Treasury: What Can Treasurers Do to Impact Business Sustainability?
01-12-2022 | Anastasia Kuznetsova | treasuryXL | LinkedIn |
The expression “Money makes the world go round” probably underscores the importance of the finance community for the transition to a greener economy. Financial market participants can significantly accelerate the transition to a more sustainable world by directing capital flows to the most sustainable projects, assets and companies.
What can treasurers do to impact business sustainability?
Corporate Treasurers can have a substantial impact on business sustainability by allocating capital to green projects as well as incorporating ESG factors in their risk management processes. Below I will summarize some of the instruments Corporate Treasurers could use to support companies on their way to sustainability.
ESG debt: Sustainability-Linked Financing
ESG debt is perhaps one of the most common instruments that may help companies to meet their ESG goals. For instance, to achieve environmental objectives, some companies issue green bonds. The proceeds from green bonds can only be spent on funding climate-related projects, including renewable energy, construction of green buildings, installation of air pollution control systems and etc. Most green bonds issued are “use of proceeds” bonds, which determine a range of eligible green project categories for which capital raised can be used. These bonds are also backed by the entire balance sheet of the issuer. Project bonds are another popular type of green bonds for which the proceeds are earmarked for specifically identified projects and are exclusively backed by the project’s assets. While green bonds might be more relevant for large public companies, private companies may still add ESG debt in their capital structures by arranging green loans which serve the same purpose as their public market bond equivalents.
Another type of ESG debt is sustainability-linked loans (SLLs), which are even more popular than green bonds and loans. The rise in popularity of SLLs may probably be explained by higher flexibility when it comes to the use of debt proceeds. Hence, the proceeds from SLLs can be spent on general corporate purposes but not exclusively earmarked for environmental projects. Moreover, SLLs are normally structured in the form of revolving credit facilities, which enables companies to fund their daily liquidity needs if they encounter a working capital deficiency. The purpose of SLLs from an ESG perspective is to encourage companies to achieve sustainability as quickly as possible. This is done by linking loan margin to a borrower’s sustainability performance. At first, sustainability performance targets (SPTs) for the borrower are established. After that, the borrower’s progress toward SPTs is monitored on annual basis via Key Performance Indicators (KPIs). If the targets are achieved, the loan’s margin will be reduced, enabling the borrower to benefit from lower interest payments. If the targets are missed, a step-up provision applies, increasing the loan’s margin and, thus, interest payments. Such an ESG Margin Ratchet provision incentivizes the borrower of SLLs to not only achieve but also maintain a certain level of ESG performance. The public markets equivalent of sustainability-linked loans is sustainability-linked bonds (SLBs) whose coupon payments are reduced (increased) if SPTs are met (missed).
On top of ESG-related loans and bonds, hybrid instruments such as green convertible bonds are becoming more and more popular. Thus, in 2020, Neoen, a French producer of renewable energy, issued €170M of the first ever green convertible bonds in Europe. This year, the company launched another €300M offering of green bonds convertible into new shares and/or exchangeable for existing shares.
Finalizing the topic of ESG debt, it is worth mentioning that when it comes to the EU’s finance providers, and particularly credit institutions who will soon have to disclose the percentage of green assets on their balance sheet under the EU Taxonomy, it is reasonable to expect that sustainability-linked debt will be favored by creditors. Specifically, being an underwriter of ESG debt could add prestige, and improve reputation and market positioning. In contrast, non-ESG debt may experience a pricing premium since such loans are likely to worsen the “greenness” of capital providers’ balance sheets.
A few words on FX Trading, Derivatives and ESG
Although currently ESG is not widely incorporated in foreign currency trades, some banks have already started to develop FX products that have a similar structure to SLLs. Such FX products will be linked to sustainability KPIs that will measure a company’s sustainability performance against pre-defined SPTs. If SPTs are successfully achieved, then a company may receive a rebate on its FX trades or a reduction in the required FX margin.
Sustainability-linked derivatives (SLDs) are another instrument that can be adopted by Treasurers to facilitate a transition of businesses to greener operations. SLDs are particularly relevant for companies, operating in “high-impact climate sectors” such as energy and agriculture. Cash flows of SLDs are connected to the sustainability performance of counterparties that is monitored via KPIs. Having met KPIs, a counterparty in a derivative transaction may receive a higher incoming payment, or be able to make a lower payment if the transaction results in a cash outflow. SLDs are OTC derivatives, meaning that counterparties can customise the derivatives’ terms and, thus, embed other ESG incentives, i.e. reduction in margin/spread, or payment of rebate upon achievement of pre-agreed sustainability targets.
Sustainable Supply Chain as an ESG trend
Sustainable supply chain is one of the current ESG trends, particularly among retailers whose total carbon footprint mainly consists of Scope 3 emissions, which are essentially emissions of suppliers. That is why, more and more companies are trying to encourage procurers to reduce their emissions and, hence, decarbonize the supply chain. Corporate Treasurers can make a substantial contribution to this objective by arranging sustainable supply chain finance programmes. Programmes are based on early-payment principles. As a first step, a company sets up sustainability KPIs to monitor the ESG performance of its suppliers. The performance of suppliers may be measured once or twice per year. After meeting at least one of the established KPIs, a supplier is paid earlier than originally agreed. Hence, highly sustainable procurers will effectively receive better payment terms, which should encourage more suppliers to improve their sustainability performance.
Sustainability Objectives and KPIs
Almost all the above-mentioned ESG products require the establishment of sustainability targets and KPIs. This unfortunately cannot be done by Treasurers on their own but instead should be done at the strategic level by company management. Sustainability targets must be ambitious, meaning that their achievement would require a substantial transformation of business models, e.g. switching to more sustainable suppliers; divestment or restructuring of high-carbon footprint units. Practice shows that not all management teams are capable of setting ambitious targets relevant to the business. Thus, the least Treasurers could do, besides the arrangement of ESG debt or other sustainability-linked products, is to question the adequacy of the chosen sustainability objectives within their organisations. In other words, Treasurers could make sure that the answer to the question “Why did your company set up its net-zero objective?” is not “Because everyone does it” but “Because it is relevant for our core business operations”.
Thank you for reading!
Anastasia Kuznetsova